Speed read

“Most asset classes have shown a fair performance during the first five months of the year, so that means overall returns have certainly been positive so far,” says Daalder, Chief Investment Officer of Robeco Investment Solutions. “Despite all the political tensions, the high valuations of US stocks, the uncertain economic outlook, and even the wrong season (‘Sell in May’), stocks want to move higher.”

“The current environment feels a lot like picking up pennies in front of a steamroller: a reasonable probability of modest and steady gains, but a non-negligible probability of a big loss up ahead. The question for us is do we want to be in the business of picking up pennies in front of a steamroller?”

Most asset classes have fared pretty well so far this year.
Source: Robeco, Bloomberg

Pennies are still profitable

The term `picking up pennies in front of a steamroller’ is linked to Nassim Taleb, an acclaimed author on randomness and risk, whose books describe an investment strategy that has a high probability to yield a small return (pennies), and a small probability of a very large loss (steamroller). Taleb assumed that the negative outcome scenario would on balance outweigh the pennies picked up.

“The latter is certainly true in case of the steamroller (certain death), but in financial markets, much will depend on long you are successful in picking up the pennies unharmed, or how fast you can exit the market,” says Daalder. “For sure, entering the stock market at the wrong time (near the top) can give you the feeling that you have been hit by a steamroller once the correction starts: your losses are likely to outweigh your gains.”

So far, the penny picking has been the clear winner

“Having said that, for the broader stock markets, it should be pointed out that the longer-term nominal annual return has been around 8%, indicating that so far, the penny picking has been the clear winner. As such, the metaphor seems to oversell the downside.”

“Indeed, as foolish as the penny-picking may sound, it should be pointed out that it has been a very profitable strategy in most markets during the post-crisis years. Investing in high yield and credits have given investors a steady bit of extra return (spread) at the risk of a big credit event (such as a default) taking place. With the exception of the US oil sector, no big credit event has occurred, with spreads either remaining steady or even declining.”

Where’s the steamroller?

“Stocks markets on the other hand have drifted higher, and although there has been a bit of volatility at times, the big steamroller has not been hitting the paving stones. It has been pointed out by many that buying volatility (by buying the VIX index, for example) has been a steady money maker, while selling volatility (or buying protection, by selling the VIX) has resulted in a constant drain.”

Daalder says there are a number of reasons for this anomaly, led by the fact that central banks have moved from being a shepherd of the economy to a general guardian of the financial markets. Meanwhile, economic growth may have disappointed over the past five years, but this has come on the back of lower volatility of the underlying data.

In addition, a long list of political wobbles has not moved the markets all that much. “The lesson seems to have been that simply ignoring those uncertainties was the optimal outcome,” Daalder says. “This is not to say that this is correct: it is always possible that one of the uncertainties escalates.”

Pennies, dimes or dollars?

“Another way to address the nickel-picking question, is by looking at two related questions: how big is the steamroller and are we talking pennies, dimes or dollars here?” Daalder asks. “With US stocks markets rebounding by 225% from their 2009 low (including dividends, the annual return has been 18% over that period), and with US stocks now looking expensive according to a whole range of valuation measures, it is clear that the easy picking has already been done.”

“This is exactly the reason why we prefer to be overweight the European market, where we think there is more upside after a more muted market recovery since 2009 (up 80%, resulting in an annualized total return of 12%). Further upside for US stock markets is therefore closely linked to earnings growth. All things considered, the most likely outcome would be a ‘healthy’ 10% correction in stocks, not the real steamroller event.”

“Subsequently, we have so far refrained from entering the business of penny-picking in the stock market: emerging market debt and high yield have been our preferred asset classes with which to add risk so far. If we were to put up an overweight position in stocks, it would be completely momentum driven, and with a pretty tight stop-loss put in place.”